MainStreet Macro: Oil-It’s bigger than you think

The price of oil, like most things, is determined by supply and demand. But oil is unique in how its prices are set and how they can affect the economy.

Today, we drill down on three key features of oil and what rising prices mean for Main Street – and what Main Street’s reaction might mean for the global economy.

Feature 1: A few heavy hitters drive the market

As countries grow, their demand for energy increases. Man-made and natural events can disrupt that demand. 

During the pandemic lock down, demand for oil fell dramatically, causing prices to tumble. A benchmark crude fell from more than $55 a barrel to less than $4 a barrel. As the economy reopened, prices quickly rebounded.

Now, developments in Russia and Ukraine have pushed U.S. prices even higher, to more than $120 a barrel, the highest in thirteen years.

A handful of high-producing countries controls supply, with the top 10 oil accounting for nearly three-fourths of the world’s oil.

The U.S. leads the pack as the largest single oil producer, with about 20 percent of global production. Russia’s production is about only half that, according to U.S. Energy Information Administration data.

But the 13-nation Organization of Petroleum Exporting Countries produces about twice as much oil as the U.S. and essentially controls the global spigot. When supply is high, OPEC cuts production. When supply is low, it ramps up.

This highly concentrated market makes oil one of the world’s most volatile commodities.

Feature 2: It’s more than supply and demand

Supply and demand aren’t the only dynamics at play. The price of oil also is affected by trading and investor sentiment.

Lots of companies buy and use actual oil. But many also speculate, locking in oil prices with contracts that guarantee future deliveries for a certain price. These futures contracts, essentially, are promises to buy or sell oil at a specific price on a specific date.

Oil buyers and sellers enter into futures contracts for two reasons. Big oil users need to hedge the risk of price increases. Airlines, for example, want to prevent their balance sheets from taking a hit if there’s a big and rapid jump in oil prices.

Then there are investors who buy oil not because they need to fly planes or fuel trucks, but because they want to make money. Banks, hedge funds, and other financial firms buy and sell oil futures to make a profit or diversify their clients’ investment portfolios, for example.

This trading serves a purpose. Oil varies by grade, distribution region, refining, production type and more. Financial markets help establish a standard price for all of it.

Feature 3: It’s more than planes, trains and automobiles The cost of oil can ripple across a whole host of goods and services. Oil and its byproducts are used in plastic, pacemakers, asphalt and even lipstick. It’s not just shipping and transportation.

For Main Street, the pain of rising oil prices is felt most acutely at the gas pump and in the grocery store. 

The Federal Reserve and economists generally look past rising energy (and food!) prices when measuring the effect of inflation on the economy because those prices vary so much from month to month. 

Yet those same prices feed into consumer, business and investor expectations about inflation. And the expectation of higher inflation can become a self-fulling prophesy.

Yes, over time higher oil prices incentivize oil-producing countries to amp up production, which eventually lowers prices again. The wrench in this process is Main Street. If more people expect inflation to get worse, they change their buying habits, which might cause inflation to stick around longer term.

My Take

The economy gained 678,000 jobs in February and unemployment fell to 3.8 percent, very close to the pre-pandemic unemployment rate of 3.5 percent, a 50-year low. More people entered the labor market too.

But the all-around good jobs report was swallowed up by global events. Developments in Ukraine and Russia have made it likely that inflation casts an even longer shadow on the U.S. economy this year by boosting energy and food prices.

It’s a powerful illustration of the connection between Main Street and the rest of the world. 

Higher prices and higher inflation driven by global events could cause Main Street to slow spending here in the US. That in turn could contribute to slowing global growth.

Main Street is not just a local community or place. It is a concept of economic activity tied to the real-life choices made by households and businesses every day, and those choices can be shaped by events a world away.